CHAPTER 16

Currency Products

Futures on foreign exchange (FX) rates were the first financial futures contract introduced by an exchange. On May 16, 1972, the Chicago Mercantile Exchange launched trading futures on three currencies—the British pound, the Deutsche-mark, and the Japanese yen. Before that time there was little need for derivatives markets on currencies. Exchange rates were essentially fixed as a result of the Bretton Woods Agreement, which required each country to fix the price of its currency in relation to gold. With the failure of the Bretton Woods Agreement and the removal of the gold standard in 1971, exchange rates began to fluctuate more freely, motivating a need for exchange rate risk management tools. FX options and futures options did not appear until about 10 years later, being introduced by the Philadelphia Stock Exchange and the Chicago Mercantile Exchange in 1982. While exchange-traded derivatives are not nearly as active as stock index and interest rate derivatives, currency derivatives today account for about 12% of the notional amount of all OTC derivatives trading worldwide.1

This chapter has four sections. In the first section, exchange-traded and OTC FX derivative markets are discussed. In the second section, arbitrage relations and valuation methods for FX forward, futures, option, and swap contracts are provided. For currencies, the continuous net cost of carry no-arbitrage relations and valuation methods apply. The third section illustrates a ...

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